05 October 2009

Declining rents: a practical lesson in supply and demand

The economic concept of supply and demand seems simple enough. If demand for lollipops increases, but the number of lollipops produced remains the same, prices will rise (and fall if some people suddenly stop eating them). However, the application of this economics principal gets tricky. Many people assume that the demand side of the equation is some easily calculable variable, that can easily be extrapolated given the right information.

Unfortunately, demand is a fiendishly complex thing, subject to so many factors that there is often no easy way to determine how it will change, or alter.

The recent decline in rents across the USA is an excellent example of this. Why is it that rents are in decline at the very same time that fewer people are buying homes? I recall seeing articles at the beginning of the housing downturn in 2007 which proclaimed that a real-estate bust would be fantastic for landlords since demand for rental accommodations would increase. Instead, we are seeing that demand for rental properties is falling at precisely the same time that demand for acquiring homes is also down.

What this apparent contradiction of declining rents simultaneous with declining home sales shows is that demand is far more elastic than many have thought. Demand is actually a highly elastic concept, that has as much (or more) to do with peer-pressure, culture, and income levels than it does with population. In the case of rents, we are clearly seeing that people are down-sizing their housing needs due to a loss in incomes, or even fear of such. 4 person families that previously lived in 3 bedroom homes with a garage, are now content to live in a two bedroom apartment, and having the kids share a room. Increasing numbers of single adults are moving back to live with their parents.

All the old assumptions about how demand for real-estate could be linearly extrapolated from population can be chucked out the window.

Even the idea of supply itself is also a fuzzy concept, that is difficult to nail down. For example, we are seeing increasing numbers of home owners who are now renting rooms in their homes to help make ends meet (adding additional “shadow” supply to the rental market).

The law of supply and demand is still valid, but there is no simple equation that will tell us what will happen to either supply or demand in the future.